Analysis of developments in financial markets, economics and public policy geared towards anyone with a stake in these issues......and, yes, we all have one.

Monday, March 10, 2014

Lessons From Moscow: How Not to Build a Modern Economy

The cover story in a recent issue
of The Economist magazine detailed Argentina’s fall from grace over the past century. The piece reads like an economist’s version
of a horror film. All the gory bits are present: populist policies, ham-fisted
state intervention, fiscal irresponsibility and the frittering away of the rule
of law…not only with regard to property and business, but eventually across
society. While the purpose of the article was to serve as a warning for other
countries, one had to ask, is this
cautionary tale really necessary? After all most of Argentina’s missteps
occurred way back in the 20th century. Since then the virtues of
economic liberalization and free markets have been proven time and again.
Furthermore, myriad narcissistic populist leaders have had their clothes ripped
off, exposing the dangers of concentration of power.

Unfortunately, there are still countries
following this disastrous template, including Argentina itself as well as a
handful of other Latin American neighbors. The romance of leftist politics and
fiery leaders apparently always has a welcoming audience in balmy southern
latitudes. But one country in a decidedly frostier climate has also made a pronounced
turn towards a potentially ruinous economic path: Russia. Much like the wayward
LATAM countries, Russia is sowing the seeds of underperformance despite a
nearly unequaled bounty of natural resources. The country also has in its favor
a well-educated populace, especially in the realm of science and math, areas
where a certain unnamed global superpower
is egregiously lacking. At first glance Russia has experienced an economic
renaissance since the nadir of the post-Soviet era, yet this is likely to prove
ephemeral given the government’s consistent jettisoning of the policies and
tools necessary to create durable economic growth.

Russia has commanded its fair share
of media coverage of late due to its adventures in Crimea and the unceremonious
dumping of its kleptocratic water boy in Kiev. There is plenty of commentary
available on the geopolitical chess match occurring in Ukraine, but this
posting is not one of them. Instead, true to this page’s mission, the focus is
on economics and how it relates to the investment universe; in this case with
regard to Russia. It is not a far stretch, however, to draw a connection
between the country’s current economic trajectory and its fitful grasps at the fading
shadows of imperial grandeur.

The Wild East

At the risk of dating myself, your
commentator recalls a description of the Soviet Union by one of his university
professors stating, “…it is a third-world economy with a first-world military.”
We know how that story ended. The collapse of the command economy gave way to
the chaos of the 1990s and its bastardized version of privatization and
capitalism. After the fleecing of the country’s commanding heights, countless
gangland shootings and a mass exodus of capital towards the anonymous valleys
of Switzerland, the country was fatigued and ready for a new beginning. Enter
Vladimir Putin. The erstwhile St. Petersburg functionary (among other things)
was the beneficiary of not only Russia’s yearning for a strong hand, but also
generous presidential powers as defined by the constitution. One-hundred bucks
for a barrel of oil did not hurt either.

Even during Soviet times, Russia
was an energy juggernaut. After a nearly decade-long swoon in production, the
wind was at the country’s back by the early 2000s with hydrocarbons leading the
way. Vast sources of industrial metals such as aluminum and nickel further
augmented economic prospects.

The rebound in growth was
impressive and soon Russia was lumped with China, India and Brazil to form the
BRIC club of large countries with rapidly expanding economies. Moscow’s store
shelves were stocked with all the creature comforts of an advanced economy and
regular flights were scheduled to London, southern France….and of course,
Zurich. But these economic advances came
at a price: the gradual curtailment of civil liberties and other tenets of a
civil society. As has been proven time
and again, once the media, courts and a viable political opposition have been muzzled,
those in power turn into self-serving crooks in pretty short order.

How Do You Say “One-Dimensional Economy” in Dutch?

In the recent kerfuffle over
Crimea, U.S. Secretary of State John Kerry commented that 19th
century geopolitical tactics had no place in the 21st century.
Russia’s misplaced sense of time is also at play in the economic realm. One
could argue that economy of the Soviet Union was more dynamic than modern
Russia’s. The USSR at least produced things across an array of industries. Those
wares may have been lousy and forced upon a captive consumer base, but at least
the factories were humming. Fast-forward to 2014 and the country has come to
redefine the concept of Dutch Disease,
meaning an overreliance on natural resources exports at the expense of a value-added
manufacturing base.

Virtually anything of worth and
complexity is imported, a situation that has only been magnified during the
decade of high energy prices. As seen above, Russia is reliant upon foreign
suppliers for many of the tools necessary to keep a modern economy buzzing
along. This includes transport equipment, machinery, office and telecom
equipment, not to mention those fancy Gucci bags and Italian fashions adorning
Moscow storefronts. The manufacture of cutting-edge goods creates a greater
amount of high-skilled jobs than does digging a hole in the ground for a pocket
of crude or a hunk of bauxite.

Creating a skilled manufacturing
and services base should be especially important for Russia as the deck is
stacked against it from the get go. Economic growth is a result of increasing
population and enhanced productivity. Russia’s populace is shrinking, and at an
alarming rate, having retrenched nearly 5% since 1990.

With regard to labor productivity,
the country dramatically lags advanced economies. To be sure, inroads have been
made from the Soviet era, but that is the consequence of an incredibly low
base. As seen below, GDP per capita in Russia is only 46% of the U.S. level and
output per hour worked reaches just 37%, lower than the rates for Chile, South
Korea and Turkey.

Red flags abound….and not those adorned with a hammer and sickle

As any investor knows,
diversification is a good thing. Russia rode the positive trend in commodities
demand to relative prosperity. But as the super-cycle
has tapered off along with previously red hot growth in energy-intensive emerging
markets, the country’s lack of diversification is coming back to haunt it. GDP
growth, along with fellow commodities producer Brazil, has consistently lagged
that of the other BRIC countries, China and India.

As a result, national accounts are
less vigorous than they were a few short years ago. The current account, while still positive, has
trended down to nearly 2% of GDP (the U.S. should be so lucky). Also the
federal budget, built to generously hand out patronage to favored segments of
the population, has dipped into the red. Purportedly crude at $100 a barrel is
required for the petro-state…and that’s what Russia has become….to balance its
books.

Lower energy prices are not the
only thing Russian officials need to worry about. Production growth for both crude and natural
gas has slowed from the boom period experienced a decade ago. Crude production
between 1996 and 2004 grew at an annual clip of 5.5%. Between 2005 and 2012 it
slowed to 1.5%. The drop may be partly explained away by the curtailment of
production in light of the global recession, but other data suggest that additional
negative factors are at play. Russia’s share of global crude reserves has
dipped from 6.1% in 2006 to 5.2% in 2012. Furthermore, growth in proven
reserves has all but stalled.

These trends cast a dark shadow as
Russia has become overly reliant upon royalties from the energy industry as its
main source for hard-currency. While the Central Bank’s foreign currency
reserves are still at lofty levels, accumulation has slowed and at some point
those funds may be needed to defend the Ruble against deprecation. Since its level
of 27.4 to the USD in 2011, the Ruble has lost nearly 25% of its value, with
10.4% of that decline coming since late-December as a consequence of traders
freaking out over Putin’s Black Sea adventurism.

Capitalism….with a little “c”

Overdependence on commodities
exports is just one hurdle facing Russia’s economy. The balance of power between the private
sector and state has swung towards the latter, with key industries dominated by
state-controlled firms. This is illustrated in the constituents of the MICEX
equities index, which largely reads like a who’s who of state-owned
enterprises, including giants Gazprom, Sberbank and Rosneft. This concentration
is aggravated by the practice of corporations maintaining control by floating
only a portion of their shares. Of the ten largest listings on the MICEX,
representing 73% of total market cap, the average amount of free floating
shares is 39%. Just enough to keep a minority shareholder awake at night. With such
suspect underpinnings, it does not take much….say the unprovoked armed invasion
of a neighboring land…to send equities investors running for the exits. And
this is exactly what has occurred with the MICEX plummeting 11% in the past
month.

Portfolio investors are not the
only ones proceeding with caution. Foreign Direct Investment (FDI) has yet to
recover from the global downturn. From 2000 to 2008, FDI…admittedly from a low
base…averaged 51% annually. In the ensuing four years the gain averaged only 11%.
With foreign investors…especially in the energy and materials space…getting
bullied about, is this to anyone’s surprise?

In addition to the heavy hand of
the state, petty corruption and regulatory inefficiency continue to be a drag. Needless
to say, none of these characteristics are conducive for nurturing an innovative,
wealth-generating private sector. In this environment, is it any wonder that
while young Czech computer scientists have created global leading
cyber-security firms, their Russian counterparts are renowned for being the world’s
most menacing hackers? It isn’t like the country’s leaders are moral icons.

Consider yourself warned

As long as we are quoting past
professors, another one opined that the best way for an investor to approach Russia
was to avoid it. The comment was made in the aftermath of the 1998 Ruble devaluation,
so within that context perhaps it was a prudent strategy. Yet despite many of the advances since then,
investors still must approach the country with extreme caution. In a world
dependent upon interconnected capital flows, reticence towards Russian assets by
foreign money is itself a hindrance to growth. This risk could become even more
pronounced should growth in hydrocarbon exports continue to diminish and the
Ruble continue its slide, especially given the country’s reliance on Euro and
Dollar denominated manufactured imports.

For those investors continuing to
go forward, it isn’t like you have not been warned. The country’s elites make
little effort to hide their hardball business tactics. As for commercial
partners, such as energy hungry Germany, the inability to confront Russia’s
geopolitical dalliances is a direct consequence of not diversifying their
energy resources (e.g. an alternative to Nord Stream and the unplugging of the
nuclear sector).

The Gucci Revolution

Rounding our way back to any
linkage between Russia’s Potemkinesque economy and its latest exercise in Machtpolitik, one plausible connection
is that the gents in the Kremlin recognize their economy is ill-equipped to
raise the living standards of ordinary Russians anymore (without relinquishing plum
positions in key industries). So as a diversion, they beat the nationalist war
drum. This tactic is especially effective when resuscitating the ever-lurking
fascist scourge to the west, which evidently includes every European between
the Dnieper and the Atlantic. Or the plutocrats have simply come to believe
their own rhetoric on having rightfully returned The Motherland to Tsarist
glory.

But this is neither the 19th
nor the 20th century. Russians, especially the young, understand how
the rule of law and free market principles lead to increased living standards.
This is no East vs. West argument. Yes, many were coopted by the relative
stability which marked the early years of the Putin regime, but the loss of
freedom and opportunity have reached a tipping point where the future prospects
of a nation are at stake. With the Internet and frequent travel to western
capitals, the genie cannot be put back in the bottle. In keeping with the
tradition of giving every popular uprising in the 21st century an
easy-to-digest moniker, we can call this one…should it ever occur… The Gucci Revolution.

Despite its volatile and sometimes
dubious history, it is hard to discount Russia’s place in the international
community. After all this is the country that gave the world the brilliance of
Dostoyevsky, Tchaikovsky, Stravinsky and Maria Sharapova. Rather than suppressing
these resources…as well as invading former territories…..the Kremlin should
instead harness them by casting away the chains holding back a potentially
top-tier global economy.

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About Me

During my career as an investment analyst, several developments from the realms of financial markets, economics and public policy struck me as highly relevant, not to me in my role as a market observer, but in my role as a citizen. The subjects covered on these pages are not aimed at fellow investors or policy junkies, but to the broader population, which needs to recognize the shifts occuring in the economy and understand their consequences, as well as those of government policy.